The Investor's Guide To Real Estate Crowdfunding

Cofounder and CEO of RealtyShares, a crowdfunding for real estate platform.

With the passage of the JOBS Act in late 2012, crowdfunding has caught fire and is being used to raise money for everything from startups to small businesses. In fact, in 2013 alone, crowdfunding, which includes debt, equity, rewards and donation based crowdfunding, is responsible for approximately $5 billion worth of capital raised.

This success is no where more obvious than for real estate. Although Crowdfunding for real estate is a relatively new space, over the last year, crowdfunding for real estate platforms have been responsible for raising over $100 million for hundreds of real estate properties across the U.S. And this model is being replicated all across the world with crowdfunding for real estate platforms sprouting up in countries like China, Japan, Australia, Canada and France.

The basic premise for real estate crowdfunding is simple. An investor can access individual real estate properties through an online platform and pool money with other investors to invest as little as $1,000 into that specific property. However, despite this simple premise, there are still misconceptions about the basic structure (both legal and otherwise) of a crowdfunded real estate investment. And as the founder and CEO of a real estate crowdfunding platform I’ve encountered these misconceptions firsthand.

It’s Not Really Crowdfunding

First, although crowdfunding for real estate has been praised as a way to democratize the real estate investment market by giving mom and pop investors an opportunity to invest, most platforms to date are only accessible by Accredited Investors. In fact, the JOBS Act provisions that were supposed to make crowdfunding available to the masses have yet to become effective and most platforms instead rely on an exemption that predates the JOBS Act known as Regulation D, Rule 506.

Debt v. Equity – They Aren’t the Same

Second, real estate crowdfunding has two subgroups – debt and equity. In the case of a crowdfunded real estate debt investment, the participating investor is acting as a lender for rather than an owner of the property. As such, the investor is entitled to monthly interest as well as a return of any unpaid principal at maturity but does not receive the benefit of property appreciation. The investment is also secured by the property and if the borrower fails to pay interest and principal when due, the investor has recourse and can recover his/her investment through a foreclosure. Conversely, with an equity investment, the investor is an owner of the property, albeit an indirect one. As such, the investor is not secured by the real property and has little recourse if the property investment turns out to be a bad one. However, this additional risk also means the investor is entitled to a greater return, which is usually achieved through property appreciation and realized when the property is eventually sold. To date, approximately 20% of crowdfunded real estate investments have been structured as debt with 80% structured as equity.

You Don’t Really Own Real Estate

Third, investing in a crowdfunded real estate investment does not actually make you an owner of real estate. Rather, you become a member of a Limited Liability Company that in turn holds title to real property (in the case of equity) or makes a loan secured by real property (in case of debt). Your ownership in the LLC is considered personal property rather than real property and your right to share in the income generated at the property is set forth in a governing document for the LLC called an Operating Agreement.

It’s not a REIT

Finally, contrary to common belief, investing in a crowdfunded real estate investment is not like investing in real estate stock. When you invest in real estate stock, or more formally known as a REIT, you are investing in a company that owns and operates various real estate investments. You do not choose the specific properties. Both types of investments have their pros and cons. REIT’s offer instant liquidity whereas with crowdfunded real estate you’re locked in until an exit event such as loan maturity or the sale of the property (which can range from six months to seven years). On the other hand, crowdfunded real estate offers more control and transparency and greater diversification from the stock market whereas REIT’s are more correlated with the stock market and thus experience similar volatility.

Crowdfunding is continuing to evolve and it will be exciting to see what changes come about in the real estate crowdfunding industry over the next year. One thing is certain, investor confidence in real estate is back and investors are looking for new and creative ways to participate. Accordingly, it is now more important than ever for investors to understand exactly what they are purchasing when participating in a crowdfunded real estate investment.